Why I’m avoiding Fortescue Metals Group Limited

Investor sentiment towards iron ore miners has improved since the start of the year. This has pushed Fortescue Metals Group Limited (ASX: FMG), Rio Tinto Limited (ASX: RIO) and BHP Billiton Limited (ASX: BHP) higher. Rio Tinto is up 16%, BHP Billiton is 27% higher and Fortescue has risen by 161% year to date. Although demand for iron ore has firmed up this year, I believe that the steel-making ingredient and iron ore-focused Fortescue face an uncertain future.

To keep reading, enter your email address or login below.

Enter your email below for FREE access to this article and all the content on the site. Also receive Take Stock, The Motley Fool's unique daily email on what's really happening with the share market. You may unsubscribe any time.

Investor sentiment towards iron ore miners has improved since the start of the year. This has pushed Fortescue Metals Group Limited(ASX: FMG), Rio Tinto Limited(ASX: RIO) and BHP Billiton Limited(ASX: BHP) higher. Rio Tinto is up 16%, BHP Billiton is 27% higher and Fortescue has risen by 161% year to date. Although demand for iron ore has firmed up this year, I believe that the steel-making ingredient and iron ore-focused Fortescue face an uncertain future.

Increasing demand

A key reason for improved investor sentiment towards iron ore miners such as Fortescue is increased demand from China. Stainless steel production in China has increased by 7% year-on-year. This is due to Chinese government stimulus which has boosted the construction industry. This has caused the price of iron ore to rise by 30% to US$56 per tonne. In the short run, further demand increases could take place in China and across Asia as favourable economic policies act as positive catalysts.

Increasing supply

Alongside rising demand for iron ore is a forecast for a faster increase in supply. Brazil and Australia are expected to increase their iron ore production by 200 million tonnes between now and 2020. This includes major projects such as Vale’s ramp-up in production at its S11D project. This means that there is likely to be a glut in supply of iron ore. According to Fitch, the price of iron ore will decline to US$45 per tonne over the medium term. This would hurt the financial performance of Fortescue.

Further, accidents at iron ore operations in Brazil, as well as weather-related disruptions, have caused restricted supply in 2016. This has contributed to the price rise of iron ore. Once these one-off factors are removed, I believe that the price of iron ore will come under more pressure.

Outlook

Although Chinese stimulus has boosted its construction industry, the outlook for China’s housing market is uncertain. Several Chinese cities have recently restricted home purchases in an attempt to cool a rapidly overheating property market. This could cause demand for steel to fall as housing transactions decline in number.

This is expected to contribute to an increase in the oversupply of iron ore between 2016 and 2018. The global surplus is forecast to rise to 56 million tonnes per annum by 2018 from today’s 20 million tonnes per annum.

Finances

Fortescue has made real progress in cutting its cost base. Its operating costs declined by 43% in the 2016 financial year and its debt level was reduced by US$2.8 billion to US$6.8 billion. However, its interest coverage ratio was 2.7 in the 2016 financial year. This shows that a reduction in the price of iron ore could lead to financial difficulties even if Fortescue can cut costs even further.

Its debt is also US-denominated. There is potential for the US dollar to strengthen due to forecast interest rate rises. This could put Fortescue’s financial position under greater stress through making debt repayments more expensive.

Although iron ore has experienced an improved performance in 2016, in my view an increase in supply plus uncertain demand will cause its medium-term performance to disappoint. Fortescue’s status as a single commodity mining company with high debt levels means that it is a stock I’m avoiding.

Motley Fool contributor Robert Stephens has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

Two New Stock Picks Every Month!

Not to alarm you, but you’re about to miss a very important event! Chief Investment Advisor Scott Phillips and his team at Motley Fool Share Advisor are about to reveal their latest official stock recommendation. The premium “buy alert” will be unveiled to members and you can be among the first to act on the tip.

Don’t let this opportunity pass you by – this is your chance to get in early!

Simply enter your email now to find out how you can get instant access.

By clicking this button, you agree to our Terms of Service and Privacy Policy. We will use your email address only to keep you informed about updates to our website and about other products and services we think might interest you. You can unsubscribe from Take Stock at anytime. Please refer to our Financial Services Guide (FSG) for more information.

CLAIM YOUR FREE SUBSCRIPTION NOW

What's REALLY going on in the share market...and what do we think is the BEST and SAFEST way to make some money right now? Discover our experts' take on the ASX with your FREE subscription to The Motley Fool Australia's weekly email Take Stock...

By clicking this button, you agree to our Terms of Service and Privacy Policy. We will use your email address only to keep you informed about updates to our website and about other products and services we think might interest you. You can unsubscribe from Take Stock at anytime. Please refer to our Financial Services Guide (FSG) for more information.